What do over $100 per barrel oil prices really mean for the global economy?
According to Stephen King, chief economist at HSBC, the situation doesn’t bode well for the recovery at all.
His Friday research piece beings:
*History offers some worrying messages
*This oil price spike couldn’t be happening at a worse time
*The bigger concern is ultimately recession, not inflation
First off, these are the key reasons to worry why it’s all in fact a bit 2008:
In 2008, oil prices approached USD150 per barrel. Shortly afterwards, the global economy collapsed. There were, of course, other problems at the time – an imploding US housing market, the beginnings of a securitisation crisis, the collapse of Lehman Brothers – but events three years ago nevertheless offer plenty of evidence that substantial changes in oil prices are big news for the global economy. Indeed, for those who believe the global economy is ultimately fuelled by oil and gas (as opposed to, for example, excessive credit), events in 2008 simply confirmed a pattern seemingly in place since the 1970s.
Chart 1 shows the level of oil prices in real terms (adjusted using the US consumer price index) tracked against US recessions. Regular as clockwork, increases in oil prices of more than 100% lead to declining GDP.
While King admits we’re not quite there yet — we might have to wait until prices touch the $150 per barrel mark before we reach breaking point again — there are enough warning signs around for investors “to feel a touch edgy”.
First, though, we still have to work out exactly why it is that oil prices are so high.
As King points out:
Late last year, oil prices seemed to be rising for two main reasons. First, the Federal Reserve and other central banks in the developed world were pursuing unconventional policies – widely seen as an abuse of the printing press – in an attempt to kick-start economic activity. As a hedge against all this “monetary madness”, dollars were converted into “real” stores of value, leading to significantly higher commodity prices. Second, because the effects of quantitative easing were felt more acutely in the debt-lite emerging world than in the debt-heavy developed world, global growth became more oil-intensive: oil consumption as a share of GDP is much higher in the emerging world than in the developed world (see table 3).
Now, however, the story has switched from demand to supply and to the epistemological difficulties nicely expressed by Donald Rumsfeld, the former US Secretary of Defense, with his “known unknowns” and his “unknown unknowns”. Since the beginning of this year, the pace of increase in oil prices has accelerated hugely. Brent crude has risen by USD18 in just 55 days. It took around 100 days to deliver a similar dollar increase in the latter stages of last year.
This latest acceleration reflects, of course, developments in the Middle East (which have been covered in great detail by Simon Williams and Liz Martins, our Dubai-based economists). While Tunisia and Egypt hold little relevance for the global oil market, Libya is a different kettle of fish. It is by no means the biggest oil producer in the world – that accolade belongs to the Russian Federation and to Saudi Arabia – but it still accounts for around 2% of total output (see table 5). If the Libyan oil taps were turned off – and, in the event of a destructive civil war, remained off for the foreseeable future – either oil output would need to come from somewhere else or, instead, oil prices would have to rise.
The biggest unknown unknown has hence always been the possibility of political instability in the Middle East.
And that really is the main reason behind the most recent pick-up in prices.
In the near-term, though, the bigger question is how all of this will relate to so-called second round effects.
As King explains:
Higher oil prices can easily damage business and consumer confidence via both an immediate hit to real incomes and the uncertainty generated over future real income (will oil prices stay at the new higher level or, worse, will they go up even further?) As a result, activity weakens even further.
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If a country’s capital stock was installed on the basis that oil prices would average, say, USD50 per barrel in future years but oil prices then doubled, at least some of that capital stock would now be loss-making and, thus, be scrapped. In other words, as demand in an economy falls, so does its supply potential, leading to uncertainties over the amount of spare capacity.
On their own, rising prices will simply squeeze real wages but what if nominal wages rise too? At the moment, this seems like a bigger risk for the emerging world than for the developed world but there are plenty of Western policymakers now becoming increasingly nervous. Most obviously, three members of the Bank of England’s Monetary Policy Committee (MPC) are now in favour of rate hikes, reflecting worries over wage growth and rising inflationary expectations.
And as for food for thought, he leaves us with this nugget:
Finally, there is a lesson from history. Following the Iraqi invasion of Kuwait, the Bank of Japan decided to fight the near-term inflation threat associated with higher oil prices and put to one side the deflationary forces slowly making an appearance in other parts of the Japanese economy. The policy worked. Inflation came down. But, as we now know, the longer-term costs were enormous: stagnation, deflation and economic underperformance. Dealing with a near-term inflation threat is all very well but, with oil price spikes, there’s typically no such thing as a free lunch.
Full report available in the Long Room.
Related links:
Emerging contagion – FT Alphaville
It’s not a liquidity crisis, it’s an energy crisis stupid - FT Alphaville
James Bullard and QE2 – oil price update - FT Alphaville